Why this week’s market action is crucial

Bonds DID NOT violate the major decade long down-trend line for bond-rates in
the 5.2-5.4% zone. Until this major trend-line is broken, a full-fledged bear
market in stocks is not likely. However, even if a slowdown develops in the US
and China, and bond-rates do not move much higher (probably our preferred
scenario at least right now), global equity and commodity markets are STILL
likely to correct more before this move is over. The rally may be better for
exiting net longs than buying more stocks. Until and unless we get strong
breadth, strong volume, and some top RS/EPS new highs to buy, this rally may not
be the one to participate in with much if any allocation.

Further evidence of a US slowdown in economic growth as well as in China will
probably help the market longer-term, but may not in the short-term. Volatility
is likely to be quite strong. The environment is not clear — and as W.D. Gann
stated, “WHEN IN DOUBT STAY OUT AND DON’T GET BACK IN UNTIL YOU’RE SURE.” I
suggest keeping your powder dry and extremely heavily in cash, with fairly
balanced long-shorts in core positions only at this time.

Bonds have bounced off of the long-term decade long trendline support area over
the last couple weeks. A CLEAR break of the 5.3% or so yield area and 82 area in
TLT
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The dollar has consolidated here, but remains critical to watch. A FAST further
breakdown of the dollar and breakout of Euro to new highs — around 135 on EUR
and FXE
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than the other currencies for the first time in nearly a year — as base metals
and precious metals got FAR ahead of themselves and me be setup for prolonged
correction/consolidation. The vertical nature of the run-up in base metals such
as copper and zinc has me very worried that we are seeing potential MAJOR tops
in the making here. Even though this remains a secular theme long-term, I would
advise cutting exposure to the bone in base metals, with only half of core
positions remaining on any break of this week’s lows in copper and zinc
together.

Let’s take a brief look at some of the key support tests we’re watching. OIL is
testing its 200-day MA again this year
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level is holding tentatively. A move below 64.5 on USO sets up a test of the
60-62 level, and if this gives way, oil is likely to experience a much more
significant correction than any we’ve seen since the 2002 low. The last MAJOR
correction lasted from late 2000 just above 40 until late 2002 just below 19.

SPY
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not yet with impressive volume. I believe investors should really wait for a
couple strong-volume rallies and strong breadth rallies before sticking a toe in
the water. Emerging Markets were soaring prior to this correction. They have
reacted VERY sharply, and some markets, like India, look particularly
vulnerable.

EEM
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long-term outperformance of emerging markets will take a serious breather here
and would pare positions on this rally nearly completely on this theme. EEM
breaking below 90 on volume should be a “dump what’s left” signal and a real
warning sign for EM troubles. Again as we stated last week, what would be most
constructive here would be tests of approximate 200 ma levels, consolidations
for a few weeks or more, and then HIGH VOLUME rallies off of these levels.

We continue to suggest that investors should be playing defense mostly. Remember
that the goal of a successful trader/investor is to only risk precious capital
when the odds are strongly in his/her favor and when the reward/risk ratio is
strong. There are few such investments here that meet that criteria, and so
sometimes the sidelines, nearly fully in cash, is the best place to be
temporarily.

I tried over the last two months to put out a subtle warning to investors
regarding the market. As I’ve sought to emphasize over the last month or two, I
continue to suspect strongly that the period directly ahead is one where it may
be ABSOLUTELY CRITICAL for investors to have a solid grasp and understanding of
the Big Picture Macro background of global markets, the top secular themes, and
the huge vulnerabilities of this environment. A potential MAJOR SHOCK to the
markets is brewing and those unaware could easily be sideswiped. The current
market behavior only reinforces the accuracy of this view. That is why I wrote
the “2006 Investment Roadmap” (see below) which is my best effort at thoroughly
explaining the global macro picture and its precarious state as well as what to
watch closely to monitor how massive risks are developing.

Whether this is a REAL bear market we cannot yet say. Investors should be
defensively postured while the market provides evidence. Key markets need to be
watched and key levels as referenced above. Let’s sit mostly on the fence here
and let others risk assets in a risky environment while the market tells its
tale. We still suspect a soft-landing is quite possible, but positive action
needs to develop in bonds, the dollar, and the market to confirm this view.

Our US selection methods, our Top RS/EPS New Highs list published on
TradingMarkets.com, had readings of 11, 19, 19 and 34 with no breakouts of 4+
week ranges, no valid trade meeting criteria, and no close call. This week, our
bottom RS/EPS New Lows recorded readings of 14, 10, 10 and 12 with 4 breakdowns
of 4+ week ranges, no valid trades and no close calls. The “model” portfolio of
trades meeting criteria was only long in WIRE and if investors weren’t stopped
out on the break of 37.5 they should use an ops below last week’s lows now.